COMMODITY ETFS EXPLAINED: STRUCTURES, COSTS AND RISKS

What Are Commodity ETFs?

Commodity Exchange-Traded Funds (ETFs) are investment funds that provide investors exposure to physical commodities, such as gold, oil, or agricultural products, without requiring direct ownership of the underlying materials. These funds trade on stock exchanges like individual equities, allowing both retail investors and institutions to participate in commodity markets efficiently.

Commodity ETFs serve various investor needs, including portfolio diversification, inflation protection, and speculative trading. They can track a single commodity (e.g., crude oil), a basket of multiple commodities (e.g., energy or agriculture), or an index representing a broad commodity market segment.

Types of Commodity ETFs

There are several structures of commodity ETFs, each designed with specific strategies:

• Physically-backed ETFs: These funds hold the actual physical commodity in storage, common with precious metals like gold, silver, and platinum. For example, the SPDR Gold Shares (GLD) ETF holds physical bullion in vaults and reflects gold's spot price movements.
• Futures-based ETFs: These ETFs invest in commodity futures contracts rather than physical assets. They are common for commodities that are impractical to store or transport, such as crude oil or natural gas.
• Equity-based commodity ETFs: Instead of holding commodities or futures, these ETFs invest in stocks of companies involved in commodity production or exploration. An example would be a fund focused on mining or energy companies.

How Commodity ETFs Are Structured

Futures-based ETFs are typically structured as open-ended funds or grantor trusts. The fund manager rolls contracts forward regularly when they near expiration, purchasing new futures to maintain exposure. This rolling process can result in performance discrepancies between the fund’s returns and the spot price movements of the underlying commodities.

Commodity pools, structured under the Commodity Exchange Act, may also be used and are regulated by the Commodity Futures Trading Commission (CFTC). Pools are often employed when the fund trades in futures and derivatives extensively.

Advantages of Commodity ETFs

• Liquidity: Most commodity ETFs trade actively, enabling easy entry and exit.
• Accessibility: Investors gain exposure to commodities without the risks and logistics of physical storage.
• Cost efficiency: These funds offer lower management fees compared to actively managed commodity funds.
• Transparency: With daily portfolio disclosures and real-time pricing, ETF investors benefit from a clear view of holdings and performance.

How Do Commodity ETFs Trade?

Commodity ETFs are listed on major stock exchanges and can be bought or sold throughout the trading day, just like shares of stock. The quoted price reflects the estimated net asset value (NAV) of the fund's holdings, though in futures-based ETFs, deviations from NAV may occur due to market inefficiencies or investor sentiment.

Some ETFs follow commodity spot prices directly, while others match the returns of a futures-based index. The fund provider is responsible for choosing the most representative benchmark and ensuring correlation between the ETF and the underlying assets.

Creation and Redemption Process

A defining feature of ETFs is the creation and redemption mechanism, which helps maintain price alignment with the NAV. Authorised participants (APs), usually large financial institutions, play a key role by delivering or redeeming baskets of the underlying assets in exchange for ETF shares. This process mitigates significant price premiums or discounts.

Commodity ETF Structures by Asset Type

• Metals: Generally physically backed. Gold and silver ETFs often hold physical reserves audited regularly, appealing to investors looking for inflation hedges or alternative currencies amid economic uncertainty.
• Energy: Futures-based. Crude oil and natural gas ETFs use front-month futures contracts. Since these ETFs do not store oil tanks or natural gas caverns, futures provide synthetic access to price movements.
• Agriculture: Also tend to be futures-based. Crops like wheat, soybean, and corn cannot be stored in large quantities by funds. Futures exposure is preferred, though this introduces additional complexity, such as seasonality and roll timing.

Inverse and Leveraged ETFs

Some commodity ETFs offer leveraged exposure (2x or 3x returns) or inverse returns (profits when the commodity price falls). These structures amplify daily price movements and are typically unsuitable for long-term holders. Leveraged ETFs require frequent rebalancing and are more affected by market volatility and compounding effects.

Commodity Index ETFs

These funds track indices comprising a broad range of commodities. Examples include the Bloomberg Commodity Index or S&P GSCI. Index ETFs provide diversified exposure across commodity sectors like energy, metals, and agriculture, which helps spread risk.

Tax Considerations

Tax treatment varies depending on the ETF’s structure and local tax laws. Physically-backed precious metals ETFs may be classified as collectibles, incurring higher capital gains taxes in some jurisdictions. Futures-based ETF gains may be subject to distinct rules, including mark-to-market accounting.

Always consult a tax professional to understand regional obligations and how they impact after-tax returns.

What Are Hidden Costs in Commodity ETFs?

While commodity ETFs often advertise low management fees, additional—and sometimes hidden—costs can erode investor returns. These include:

• Roll yield losses: Particularly in futures-based ETFs when contracts are rolled forward.
• Contango: A futures market condition that leads to negative carry costs.
• Tracking error: Differences in the performance of the ETF compared to the underlying index or spot commodity.
• Expense ratios: Though published, they don’t capture all trading and operational expenses.

Understanding Contango and Backwardation

Futures prices consist of the spot price plus a premium for time, known as the cost of carry. When the future price is higher than the spot price, the market is in contango. Conversely, backwardation occurs when the future price is below the spot price.

Contango is common in energy markets. Holding a futures position in a contango market means selling expiring contracts at a lower price and buying new ones at a higher price—creating a consistent negative drag, known as roll decay.

Roll Yield Explained

Roll yield is the gain or loss incurred from replacing expiring futures contracts with new ones. In backwardated markets, roll yield can be positive, benefiting investors. However, in contango environments, the roll yield is negative, gradually reducing portfolio value over time, even if the spot price remains stable.

For example, an oil ETF that rolls over contracts monthly may buy future contracts at a premium and continually realise losses during each roll cycle. Over several months, these small losses compound, contributing to major underperformance when compared to the raw commodity price.

Managing Roll Risk

ETF issuers use different strategies to mitigate roll-related losses:

• Optimised roll strategies: Instead of always buying the next monthly contract, some funds choose futures further out on the curve to improve roll yield.
• Dynamic rebalancing: Adjusting roll frequency or contract tenors based on market conditions.
• Diversification: Tracking indices composed of multiple commodities can smooth out the adverse effect of roll losses in a single market.

Performance and Tracking Error

Performance of commodity ETFs may diverge from the expected index or spot performance due to tracking error caused by roll yield, management fees, and operational execution. Analysing the ETF’s historical performance versus its benchmark can highlight potential misalignments.

It’s essential for investors to explore total return—not just spot price movements—when evaluating ETF performance. Some commodity ETFs notably underperform their benchmarks in contango-heavy markets.

Due Diligence Tips

• Review the ETF’s prospectus to understand the rolling mechanism.
• Track past roll losses and compare fund performance against spot prices or commodity indices.
• Assess whether a physically-backed or futures-based structure better suits your investment horizon and risk tolerance.

Understanding hidden costs is crucial for long-term success with commodity ETFs. These instruments can play a valuable role in a diversified portfolio but require careful analysis and management to avoid common pitfalls.